Tuesday, 16 October 2007

Credit market turmoil and monetary policy

I had not much bothered to link to the many articles that have analysed the causes of the credit market turmoil partly because in my opinion, most of these analyses, especially those from the mainstream media, failed to put emphasis on the root of the problem. Wolfgang Munchau's article at the FT is one of the exceptions.

Two months after the beginning of the credit crisis, the monetary policy establishment has reached a consensus on its causes: the complexity of some of the instruments, shortcomings in the mathematical models, weakness in risk management and, of course, the role of the ratings agencies...

I concede that each one of these factors contributed to this crisis. But...I believe that the explosive growth in credit derivatives and collateralised debt obligations between 2004 and 2006 was caused by global monetary policy between 2002 and 2004.

In parts of 2002-04, both the US and Europe experienced negative real interest rates...

... It means that those who have access to credit at that rate – in this case commercial banks – have an interest in borrowing an infinite amount... In a world of perfect credit markets, one would expect negative real interest rates over a long period to cause a credit bubble...

[I]t is time to learn the main lesson of this crisis, which is that credit matters for monetary policy, a fact over which many central bankers are still in denial.

One shortcoming in the article though is that while it specifically points fingers at the Fed and the ECB, it fails to mention the roles that the BoJ and the PBC played as well.

Citing the article, Yves Smith at naked capitalism reaches the following conclusion:

And these observations lead to some interesting corollaries: it means that central bankers cannot blindly follow inflation targets, since they can lead them precisely into this negative real interest rate territory. And it also means that central bankers do need to watch for and prick asset bubbles if they are the result of overly expansive monetary policy. Note that this recommendation is at odds with the current orthodoxy which holds that central bankers can't possibly second guess the markets and call a bubble for what it is, and even if they see one, it's not their job to intervene.

Indeed, if Alan Greenspan is right about higher future US inflation and interest rates go up to 10 percent to fight it, imagine what that would do to financial markets.

Ultimately, though, the problem may be that central banks rely too much on benchmark interest rate target-setting. If you use one tool to control one variable -- more or less what the ECB is doing -- you risk other variables fluctuating wildly. If you use one tool to control two variables -- more or less what the Fed is doing -- you risk falling between two stools.

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